2009-11-19

Why government deficits are a problem

Think of an economy this way: the people in any economy buy goods and services from one another and from the outside. In any given time period, one person, one company or one group/sector might use credit in order to buy more goods and services than it makes in income. It’s like spending future income by using credit. This puts that individual, company or group/sector in deficit i.e. they have spent more money than they have earned. Now obviously, if one sector is in deficit in a given period (i.e. they have spent more capital than they have earned), then the other sectors are in net surplus (i.e. they have received more cash than they have earned).

Let’s give these groups/sectors of the economy names: the private sector, the public sector and the foreign sector. Giving the groups names makes it plain that if the public sector is in deficit, the combined foreign and private sectors must be in surplus. Simply put, if you look at all of the households and businesses that make up the private sector and aggregate them together, you can determine if the private sector has a net surplus or a net deficit in any individual time period. And if the private sector has a net surplus, the combined foreign sector and public sector must have a deficit for that time period. The sector financial balances move in concert.

What this means for today is that a government which reduces its deficit in a given time period is forcing an equal reduction in surplus in the private and foreign sectors. So that means, in aggregate, the private sector and the foreign sector will reduce the surplus cash it is taking in over what it spends.

I see this viewpoint as being very blinkered. I mean, if the recession is destroying the ability of the non government sector to save, and if the government runs deficits such saving increases, then what is the point of even having taxes? I mean, why not simply remove taxes completely and have the government simply borrow what it needs and run massive, massive deficits all the time? And if people are worried that the government can't pay the money back, why not simply borrow more money to pay off increasing debt levels?

Businesses can close, individuals can go bankrupt, but governments cannot be allowed to fail. If a government reaches a fiscal crisis it must transfer its problems to individuals and businesses via taxation or inflation. The alternative - letting a government collapse - will result in everything collapsing. If government can survive, then new businesses can eventually form to employ individuals. Without government, such a recovery would be impossible (unless you think anarchy is a good thing).

No business runs itself completely on debt. Acme Widget Corporation can't borrow $1 billion per year to produce widgets that it provides for free for anyone who wants one. In such a scenario, AWC will no longer be able to procure funds and the company will collapse. When it comes to government, you can't just keep borrowing money and running deficits all the time. And although government is "safe" from a financial perspective, any deficits the government run ends up having the negative effects being transferred to the economy. These negative effects are:

1. Internal: Reduced levels of government spending in order to pay back debt.

Let's assume a government runs a fixed deficit year after year and also a fixed amount of spending year after year. This government, spending $10 billion per year and borrowing $1 billion per year, may look reasonably stable in its expenses. The actual numbers themselves don't change much.

This, however, hides what actually occurs. With increased levels of debt comes an increasing amounts of debt servicing, which - if spending is kept fixed - means that the government spends less on important things (defence, law enforcement, education, health, etc) and more on debt servicing. As I pointed out back in 2008, Italy has gotten itself into so much government debt that more than 41% of government spending is directed towards debt servicing. From an accounting point of view, things are balanced... but the reality is less money going to where it is needed.

In short, what occurs when governments run big deficits is more money going towards investors and less money going towards the people. Social problems caused by a poorer population then begin to eat into GDP.

2. External: A devaluation in currency.

Because the national government is linked to the national currency, any increasing risk of government debt default results in scaring international investors. This then results in the international market repricing that nation's currency accordingly - not only does the price of borrowing increase (interest rates) but so too does the value of the currency drop. Inflation hits the nation, along with increased import prices and a drop in real wages.

An inability to control fiscal deficits was one reason why so many Latin American economies had currency devaluations during the 1970s and 1980s. This is why controlling deficits was part of the Washington Consensus.

Now while I'm not a Keynesian per se, I do agree with the idea that governments should run fiscal deficits during recessions to increase aggregate demand. However, I also believe that governments should run fiscal surpluses during periods of growth. You can't be a Keynesian during a recession and then expect to become a Reaganite during a growth period.

Some people have likened the idea of cutting deficits during a recession to be as short-sighted as Hoover back during the depression. But the United States in 2009 is much different to the United States under Hoover in 1930. It's true that Hoover shouldn't have been afraid of government debt and should've embraced deficits. but the level of public debt in the US in 1930 was minuscule in proportion to the economy. By contrast, Obama in 2009 is embracing big deficits, but the sheer amount of money already borrowed since 1981 has placed the US government into a very poor fiscal position. That is why I believe current US government deficit spending is unsustainable.